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More stress tests for UK banks

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There are two parts to this – an annual stress test based on an adverse macroeconomic scenario, and a once every two years “exploratory” stress test considering how the UK banking system might evolve over the next seven years if recent headwinds to bank profitability persist or intensify.

Annual stress test

The 2017 annual stress test is based on a severe and synchronised UK and global macroeconomic and financial market adverse scenario over the next five years, as well as an independent stress of misconduct costs.

The scenario for UK activity (a fall in real GDP of almost 5 percent), unemployment (at 9.5 percent) and property prices (residential down by 33 percent and commercial real estate by 40 percent) is similar to the 2016 stress test. But whereas last year’s scenario was based on continuing very low interest rates, the 2017 scenario has official rates peaking at 4 percent (and a depreciation of sterling of 27 percent) in response to a lower appetite of foreign investors for UK assets.

The global economy scenario is more severe than last year, with lower real GDP growth in China, more negative growth globally, and larger movements in bond yields, reflecting an assumed unwinding of the rapid growth of credit in China.

The results of the annual stress test are used to ensure that the banking system as a whole, and individual banks within it, have sufficient capital to absorb losses and maintain the supply of credit to the real economy, even in a severe stress. The “hurdle rates” above which banks will be expected to maintain their capital positions in the 2017 test have been set on the same basis as in the 2016 test. All participating banks will be expected to meet their minimum CET1 capital requirements, which averaged 6.5 percent in 2016, together with a minimum leverage ratio. G-SIBs will be held to a higher standard. Failure to meet these standards post-stress would result in banks being required to take action to improve their capital positions.

The results of the annual stress test will be published in Q4 2017.

Exploratory scenario

The exploratory scenario will run over seven years and will be based on a scenario of weak global growth, persistently low interest rates, stagnant world trade and cross-border banking activity, increased competitive pressure (reflected in narrower spreads between retail deposits and lending rates) on large banks from smaller banks and non-banks, and a continuation of misconduct costs.

The exploratory scenario is not focused on bank capital adequacy. It will focus on how banks could both meet regulatory requirements and build sustainable business models in such an environment. Banks will therefore be expected to analyse the actions – including changes to their business models - they could take to increase their returns on equity (which currently average close to zero) to their cost of equity (nearer 8-10 percent).

Individual bank results will not be published for the exploratory scenario, because of the possible commercial sensitivity of the projections banks will provide. However, the Bank of England will publish aggregate results, including the economic impact of any strategic decisions banks would make, and analysis of the implications for the future resilience of the banking sector.

Comment

The annual stress test does not contain any surprises, although it will be interesting to see how much benefit banks claim from the impact of the increase in interest rates on their net interest margins.

The exploratory scenario looks much more challenging for banks – it will not be easy for them to demonstrate a return to respectable levels of profitability under a combination of weak macro-economic conditions and pronounced competitive pressures.